The global bond rout started in China, not the US

The United States isn’t the only giant world economy subject to rising growth expectations.

Donald Trump’s election victory is blamed for a sudden spike in bond yields. More economic growth and more issuance of government debt to fund Trump’s spending plans, markets reckon, will push up inflation as well as the underlying growth rate.

The United States, though, isn’t the only giant world economy subject to rising growth expectations. China’s unexpectedly strong economic performance prepared the ground for the big bond rout even before the US elections on November 8.

The difference between 10-year and 2-year government securities in the United States as well as Germany widened sharply after the US elections, as the chart above shows. But a clear trend upward was visible since July.

Enhanced growth expectations in the world’s two biggest economies are a winning combination for world equities, and for the most depressed sectors in the world economy — raw materials and emerging markets — in particular.

The China-led trend toward higher raw materials prices was evident in the US Treasury market during the past two months.

Overall Treasury yields have not changed much, but the components of the Treasury yield (the “real” vs. the “inflation” parts of the yield) have changed noticeably. Most major governments issue bonds that are indexed to the inflation rate.

The difference between the inflation-protected yield and the nominal yield is the rate of inflation that investors expected over the life of the bond. If inflation fits this forecast, investors will get the same return by investing in nominal or inflation-protected government securities (which is why this difference is called “break-even inflation”).

In general, this measure of expected future inflation moves in line with sensitive commodity prices, for example, of oil and industrial metals.

During the last few weeks, though, we detect an “upshift” in the relationship between break-even inflation and oil. With each upshift, oil continued to influence the five-year break-even inflation rate, but from a higher level. The baseline level of expected inflation has changed.

The source of this underlying shift in inflation expectations, I believe, is China. In September, year-on-year change in China’s producer price index was positive for the first time since mid-2011. Positive price change at China’s factory gate has a reflationary effect on the rest of the world (because Chinese manufacturers won’t lower prices in international trade).

More importantly, Chinese demand for raw materials continues to grow (and grow exponentially in most cases.

Chinese demand has a direct and measurable impact on global metals prices. There is a reasonably close correspondence between China’s manufacturing PMI and the S & P/Goldman Sachs Industrial Metals Price Index during the past five years.

The impact of Chinese reflation on the world economy prior to the US election was measurable, if modest. It was noteworthy, though, that the real impact of China’s economic recovery has been far greater for Western pricing expectations than the impact of central bank quantitative easing, which failed to interrupt the West’s descent into deflation.